TM 2-1 MANUFACTURING COST CLASSIFICATIONS FOR EXTERNAL REPORTING

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1 TM 2-1 MANUFACTURING COST CLASSIFICATIONS FOR EXTERNAL REPORTING

2 TM 2-2 COST CLASSIFICATIONS TO PREDICT COST BEHAVIOR To predict how costs react to changes in activity, costs are often classified as variable or fixed. VARIABLE COSTS Variable cost behavior can be summarized as follows: Variable Cost Behavior In Total Total variable cost increases and decreases in proportion to changes in activity. Per Unit Variable cost per unit is constant. EXAMPLE: A company manufactures microwave ovens. Each oven requires a timing device that costs $30. The cost per unit and the total cost of the timing device at various levels of activity (i.e., number of ovens produced) would be: Cost per Number of Total Variable Timing Ovens Cost Timing Device Produced Devices $30 1 $30 $30 10 $300 $ $3,000 $ $6,000

3 TM 2-3 FIXED COSTS Fixed cost behavior can be summarized as follows: Fixed Cost Behavior In Total Per Unit Total fixed cost is not affected Fixed cost per unit decreases by changes in activity (i.e., total as the activity level rises and fixed cost remains constant even increases as the activity level if activity changes). falls. EXAMPLE: Assume again that a company manufactures microwave ovens. The company pays $9,000 per month to rent its factory building. The total cost and the cost per unit of rent at various levels of activity would be: Number of Rent Cost Ovens Rent Cost per Month Produced per Oven $9,000 1 $9,000 $9, $900 $9, $90 $9, $45 TYPES OF FIXED COSTS Committed fixed costs relate to investment in plant, equipment, and basic administrative structure. It is difficult to reduce these fixed costs in the short-term. Examples include: Equipment depreciation. Real estate taxes. Salaries of key operating personnel. Discretionary fixed costs arise from annual decisions by management to spend in certain areas. These costs can often be reduced in the shortterm. Examples include: Advertising; public relations. Research; management development programs.

4 TM 2-4 A GRAPHIC VIEW OF COST BEHAVIOR $6,000 Total Variable Cost Total Fixed Cost $9,000 $3, Microwaves produced Microwaves produced RELEVANT RANGE If activity changes enough, fixed costs may change. For example, if microwave production were doubled, another factory building might have to be rented. The relevant range is the range of activity within which the assumptions that have been made about variable and fixed costs are valid. For example, the relevant range within which total fixed factory rent is $9,000 per month might be 1 to 200 microwaves produced per month.

5 TM 2-5 MIXED COSTS A mixed (or semi-variable) cost contains elements of both variable and fixed costs. Example: Lori Yang leases an automated photo developer for $2,500 per year plus 2 per photo developed. Equation of a straight line: Y = a + bx Y = $2,500 + $0.02X

6 TM 2-6 SCATTERGRAPH METHOD As the first step in the analysis of a mixed cost, cost and activity should be plotted on a scattergraph. This helps to quickly diagnose the nature of the relation between cost and activity. Example: Piedmont Wholesale Florists has maintained records of the number of orders and billing costs in each quarter over the past several years. Quarter Number of Orders Billing Costs Year 1 1st 1,500 $42,000 2nd 1,900 $46,000 3rd 1,000 $37,000 4th 1,300 $43,000 Year 2 1st 2,800 $54,000 2nd 1,700 $47,000 3rd 2,100 $51,000 4th 1,100 $42,000 Year 3 1st 2,000 $48,000 2nd 2,400 $53,000 3rd 2,300 $49,000 These data are plotted on the next page, with the activity (number of orders) on the horizontal X axis and the cost (billing costs) on the vertical Y axis.

7 TM 2-7 A COMPLETED SCATTERGRAPH Y $60,000 Regression Line $50,000 $48,000 Billing Costs $40,000 $30,000 $20,000 $10,000 $ ,000 1,500 2,000 2,500 3,000 Number of Orders X The relation between the number of orders and the billing cost is approximately linear. (A straight line that seems to reflect this basic relation was drawn with a ruler on the scattergraph.) Because a straight line seems to be a reasonable fit to the data, we can proceed to estimate the variable and fixed elements of the cost using one of the following methods. 1. High-low method. 2. Least-squares regression method.

8 TM 2-8 ANALYSIS OF MIXED COSTS: HIGH-LOW METHOD EXAMPLE: Kohlson Company has incurred the following shipping costs over the past eight months: Units Sold Shipping Cost January... 6,000 $66,000 February... 5,000 $65,000 March... 7,000 $70,000 April... 9,000 $80,000 May... 8,000 $76,000 June... 10,000 $85,000 July ,000 $100,000 August... 11,000 $87,000 With the high-low method, only the periods in which the lowest activity and the highest activity occurred are used to estimate the variable and fixed components of the mixed cost. Units Sold Shipping Cost High activity level, July... 12,000 $100,000 Low activity level, February 5,000 65,000 Change... 7,000 $ 35,000 Change in cost $35,000 Variable cost= = =$5 per unit Change in activity 7,000 units Fixed cost = Total cost - Variable cost element = $100,000 - (12,000 units $5 per unit) = $40,000 The cost formula for shipping cost is: Y = $40,000 + $5X

9 TM 2-9 EVALUATION OF THE HIGH-LOW METHOD $100,000 Y high level of activity Shipping Costs $80,000 $60,000 $40,000 low level of activity Variable Cost $5/unit $20,000 Fixed Cost $40,000 $0 0 2,000 4,000 6,000 8,000 10,000 12,000 Units Sold X The high-low method suffers from two major defects: 1. It throws away all but two data points. 2. The periods with the highest and lowest volumes are often unusual.

10 TM 2-10 LEAST-SQUARES REGRESSION METHOD The least-squares regression method for analyzing mixed costs uses mathematical formulas to determine the regression line that minimizes the sum of the squared errors.

11 TM 2-11 TRADITIONAL VERSUS CONTRIBUTION INCOME STATEMENT

12 TM 2-12 COST CLASSIFICATIONS FOR ASSIGNING COSTS TO COST OBJECTS COST OBJECT A cost object is anything for which cost data are desired. Examples of cost objects: Products Customers Departments Jobs DIRECT COSTS A direct cost is a cost that can be easily and conveniently traced to a particular cost object. Examples of direct costs: The direct costs of a Ford SUV would include the cost of the steering wheel purchased by Ford from a supplier, the costs of direct labor workers, the costs of the tires, and so on. The direct costs of a hospital s radiology department would include X- ray film used in the department, the salaries of radiologists, and the costs of radiology lab equipment. INDIRECT COSTS An indirect cost is a cost that cannot be easily and conveniently traced to a particular cost object. Examples of indirect costs: Manufacturing overhead, such as the factory managers salary at a multi-product plant, is an indirect cost of any one product. General hospital administration costs are indirect costs of the radiology lab.

13 TM 2-13 COST CLASSIFICATIONS FOR DECISION-MAKING DIFFERENTIAL COST Every decision involves choosing from among at least two alternatives. Any cost that differs between alternatives is a differential cost. Only the differential costs are relevant in making a decision. EXAMPLE: Bill is currently employed as a lifeguard, but he has been offered a job in an auto service center in the same town. When comparing the two jobs, the differential revenues and costs are: Auto Differential Life- Service costs and guard Center revenues Monthly salary... $1,200 $1,500 $300 Monthly expenses: Commuting Meals Apartment rent Uniform rental Sunscreen (10) Total monthly expenses Net monthly income... $ 560 $ 760 $200

14 TM 2-14 OPPORTUNITY COST An opportunity cost is the potential benefit given up when selecting one course of action over another. EXAMPLE: Linda has a job in the campus bookstore and is paid $65 per day. One of her friends is getting married and Linda would like to attend the wedding, but she would have to miss a day of work. If she attends the wedding, the $65 in lost wages will be an opportunity cost of attending the wedding. EXAMPLE: The reception for the wedding mentioned above will be held in the ballroom at the Lexington Club. The manager of the Lexington Club had to decide between accepting the booking for the wedding reception or accepting a booking for a corporate seminar. The hall could have been rented to the corporation for $600. The lost rental revenue of $600 is an opportunity cost of accepting the reservation for the wedding. SUNK COST A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Sunk costs are irrelevant and should be ignored in decisions. EXAMPLE: Linda has already purchased a ticket to a rock concert for $35. If she goes to the wedding, she will be unable to attend the concert. The $35 is a sunk cost that she should ignore when deciding whether or not to attend the wedding. [However, any amount she can get by reselling the ticket is NOT a sunk cost. And while she should ignore the $35 sunk cost, she should not ignore the enjoyment she would get if she were to attend the concert.]

15 TM 2-15 APPENDIX 2A: LEAST-SQUARES REGRESSION COMPUTATIONS Example: Montrose Hospital operates a cafeteria for employees. Management would like to know how cafeteria costs are affected by the number of meals served. Meals Served X Total Cost Y April... 4,000 $9,500 May... 1,000 $4,000 June... 3,000 $8,000 July... 5,000 $10,000 August... 10,000 $19,500 September.. 7,000 $14,000 Statistical software or a spreadsheet program can do the computations required by the least-squares method. The results in this case are: Intercept (fixed cost)... $2,433 Slope (variable cost)... $1.68 R The fixed cost is therefore $2,433 per month and the variable cost is $1.68 per meal served, or: where X is meals served. Y = $2,433 + $1.68X, R 2 is a measure of the goodness of fit of the regression line. In this case, it indicates that 99% of the variation in cafeteria costs is due to the number of meals served. This suggests an excellent fit.